Monday, October 31, 2011

Swiss Magic and Central Bank Price-Targeting

You may recall that in September the Swiss National Bank (SNB) announced that it was going to intervene as necessary in the currency markets to ensure that the Swiss Franc (CHF) stayed above a minimum exchange rate with the euro of 1.20 CHF/EUR. How has that been working out for them?

It turns out that it has been working extremely well. Today the SNB released data on its balance sheet for the end of September. During the month of August the SNB had to spend almost CHF 100 billion to buy foreign currency assets to keep the exchange rate at a reasonable level. But in September -- most of which was afterthe announcement of the exchange rate minimum -- the SNB's foreign currency assets only grew by about CHF 25 billion. Furthermore, this increase in the CHF value of the SNB's foreign currency assets likely includes substantial capital gains that the SNB reaped on its euro portfolio (which was valued at about €130 bn at the end of September), as the CHF was almost 10% weaker against the euro in September than in August. Given that, it seems likely that the SNB's purchases of new euro assets in September after the announcement of the exchange rate floor almost completely stopped.

But why would the SNB's promise of unlimited intervention in currency markets have led to a near total cessation of those interventions? Didn't they say they would intervene more, not less?

This is a beautiful demonstration of the almost magical power that central banks can sometimes have when they target prices instead of specifying a certain quantity of intervention. Market participants correctly believed that the SNB's promise to keep the CHF/EUR rate above 1.20 was perfectly credible. As such, no one was willing to try to accumulate CHF at a price inconsistent with that floor. In fact, there has been some sense in the market that this 1.20 rate was going to be increased, which would guarantee losses for anyone holding CHF assets. As a result, market demand for CHF has fallen dramatically and the exchange rate has drifted up above the 1.20 floor set by the SNB -- all with little or no actual intervention required by the central bank.

This should be a reminder to other central banks that when they target prices by promising unlimited intervention, the market will often do most of the work for them and respect that price target out of its own self-interest.

So let's apply this lesson to another situation: the doom loop that the market for Italian debt seems to have entered. Imagine that the ECB declared an interest rate ceiling and stated that it would not allow the rate on Italian bonds rise above some clearly specified spread over German interest rates. (Obviously this should be at an interest rate consistent with long-run Italian solvency.) And imagine that the ECB backed up that interest rate ceiling by promising unlimited intervention to support it. Since the ECB can make good on that promise by simply creating more euro -- which it can do in unlimited quantities -- market participants would understand that there is no way they could break the interest rate ceiling set by the ECB. And as a result, it is entirely possible that the ECB could achieve its price target on Italian debt with minimal intervention, just as the SNB achieved with its exchange rate floor.

What's preventing the ECB from doing that? Caution, conservatism, and politics, of course. But the Swiss Franc experience reminds us that, from an economic perspective, price targeting by a central bank can sometimes make very good sense.

8 comments:

1) If the ECB were to buy Italian debt at a an interest rate consistent with long-run Italian solvency, what incentive would the Italian government have to introduce structural reforms? In fact, wouldn't it make sense for them to borrow and spend even more, given that they have a blank check?

3) Wouldn't this lead to inflation in the long run? The only way to prevent that is to sterilize the purchases - which would lead to an increase in the interest rates for German debt. The ECB wouldn't even have to do it - the market would narrow the spread immediately. Doesn't this then become a tax on the Germans, either through higher borrowing costs, or through higher inflation ?

I really agree with 1), for a lot of this negotiation seems to this economically ignorant observer to be good politics. A financial solution to the crisis would take half an hour, but a political one would take half a decade, IMHO, of course.

This just underlines the folly of constructing a "central bank" which isn't really a central bank,. The ECB is not allowed by its constitution to create unlimited resources, and so cannot make market-credible statements. The German parliament and courts have shown a very strong appetite to enforce this. Until this changes, it will remain a size-limitied institution.

To demonstrate how bizarre its setup is, if the ECB were to accept the 50% haircut on Greek debt that it is "suggesting" to private lenders, it would wipe out almost all its capital, becoming very close to technical insolvency! Fortunately, it has an exemption from the haircut.

Of course, now that the Greeks have decided to ask the people ("what, allow populations to have a say?"), the whole ill-conceived edifice may have to be revised fairly swiftly.

This post seems a little shortsighted. The SNB is buying a currency that may suffer a financial crisis and disolution. The month after it started -- one month -- you are crying victory. Imagine what is happening today in the SWF as Euro sellers seek a safe haven. I can: the SNB Euro bid has to be constant and in size.

Same thing with Italian bonds. The ECB could target, say, 4%. A crisis in, say, France, would drive Italian bond selling and force the ECB to buy a large portion of the outstanding. That means the ECB must also peg French sovereign rates. But what if there were a crisis in Germany? You see where it heads: isolated instances of sovereign mismanagement get transformed into contagion vectors for the region as a whole.

Lastly, ECB buys are no different from fiscal buys as long as there is no marginal demand for bank reserves. That is, both merely swap a short term liability for a risk asset. ECB risk asset purchases are just fiscal policy without the messiness of democracy intruding. Therefore, in Wikipedia under the word "central bank", we increasingly find this definition:

"An entity intended to make bondholders whole through a surreptitious fiscal transfer when the fiscal agent finds it inconvenient to do so."

I was stating I thought SNB's policies would likely work, it's worked in HK's case. This is akin to playing a video game against a boss who takes unlimited damage. The potential risk I see is inflation but the Swiss economy is too German for that to be much of a concern.

1) Italy doesn't need structural reforms, especially not the ones pushed by the EC/ECB. It needs growth. In the medium term, of course, there are some issues that should be adressed through policy, such as female workforce participation or the appalling level of investment in education. But, there is nothing "structural" that can fix the problems they have NOW.

Moreover, even with lower spreads with Germany, their borrowing costs won't be exactly cheap. Debt has a cost no matter what.

2) See Brad deLong's latest article for an eplanation why, in central banking, sometimes you have to say FU to law, treatise, etc.

http://www.project-syndicate.org/commentary/delong119/English

3) Not until the EZ reaches full employment. Maybe we'd see inflation in core countries, but this would be A Good Thing since it would aid in restoring competitive balance with the periphery.

This gets into the solvency vs. liquidity issue. What crisis, exactly, are you talking about? Is it a crisis that affects liquidity, like a bank run, or a fundamental solvency crisis.

If its a liquidity crisis, then a central bank guarantee will keep the interest rate low without having to do much buying themselves. If Italian bonds are trading 4% and the ECB says it has a ceiling of 3%, then there's easy money to be made buying Italian bonds low and selling high to the ECB.

But what if Italy, or France or Germany, is fundamentally insolvent? "Insolvent" is hard to define for governments, since their main asset is the ability to tax. But let's just say it means Italy has such a poor public sector that it will keep issuing hundreds of billions of Euros in bonds. Italy is not issuing those bonds to keep the Euros in a warehouse. Those bonds are going into the Italian economy. Eventually all those bonds will become inflationary and the ECB will be forced to stop buying them.

Germany and France, on the other hand, are currently AAA rated have more responsible public sectors. The only way a "crisis" there would be real is if they somehow had to issue many more bonds for the crisis. If the crisis is just that people stop buying French debt, without any change in the long-term solvency of French government expenditures, then the ECB backstop will stop the crisis permanenty.

You're basically calling for a currency peg as a form of sustainable monetary policy. Currency pegs rarely work in the long-term interest of the country maintaining the peg as they are essentially adopting the monetary policy of a foreign country which may or may not have the same economic needs as that country. This generally works for a trade surplus nation, but would not necessarily work to stimulate a trade deficit nation.

The Swiss have pegged their currency to the Euro in order to stop its ascent. This isn't stimulative per se. It just stops the bleeding. Effective monetary policy? I guess you could say that. Sustainable? No chance. Japan has been intervening in the Yen for the last 20 years. Look where its gotten them. Granted, they haven't named a price. If on the other hand, you're essentially advocating a Chinese RMB strategy then I think you have it all wrong. Pegs such as this always result in massive inflation and the potential for a currency crisis. Russia and Argentina learned this the hard way.

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The Street Light is written by economist Kash Mansori, who works as an economic consultant (though views expressed here are entirely his own), writes whenever he can in his spare time, and teaches a bit here and there. You can contact him by writing to the gmail account streetlightblog. (More about Kash.)